Can supervisors control international banks like JP Morgan?

Governance of International Banking: The Financial Trilemma

By Dirk Schoenmaker

The dramatic failure of Lehman Brothers in 2008 has raised the question whether national supervisors are able to effectively control international banks. The London Whale, the notorious nickname for the illegal trading in the London office of JP Morgan, questions the effectiveness of international supervision.

The global financial crisis has brought into sharp focus the massive costs associated with the bail out of global systemic banks, which were perceived as too-big-to-fail. The governments’ handling of the financial crisis has reinforced too-big-to-fail doctrine. As a result, the most significant regulatory reform proposals have focused on the question of how to curtail the too-big-to-fail problem. Namely how can one reduce moral hazard and rein back expectations of future bail-outs of systemic banks?

The reform agenda has two priorities: first, reducing the probability of a systemic failure with substantially higher capital standards; second, reducing the impact of a systemic failure with resolution plans. These resolution plans should allow systemically important banks to fail or, at least, to be unwound in an orderly manner without imposing disproportionate costs on the taxpayer. On top of these reforms, the Basel Committee on Banking Supervision has prepared a list of 28 global systemic banks. The capital requirements and resolution plans are even more stringent for these global banks. JP Morgan is also on this ‘hit’ list.

But is this sufficient? I think not. National supervisors follow a narrow domestic interpretation of their mandate. US supervisors focus mainly on the US operations, UK supervisors on the UK operations, etc. They pay lip-service to international coordination, but when the going is getting tough, like in the crisis, they take a domestic approach responding to political demands from the Treasury and Congress. It is no surprise that major shortfalls happen in the overseas operations, such as the hidden trading in London at JP Morgan and the questionable practice of booking repos at net value to improve the balance sheet in the London office of Lehman.

Then why is international cooperation not on the reform agenda? Politicians and supervisors find it difficult to give up national powers. But that is exactly what is needed. As international banks operate on a global scale, their supervisors should also join forces and work on a common mandate. The endgame of resolution sets the incentives for supervision. The proposals start with a burden sharing agreement among national governments to rescue international banks, if needed. In the day-to-day supervision, the Bank for International Settlements (BIS) can take a leading role and aid to oversee the global systemic banks on a consolidated basis replacing the fragmented approach by the national supervisors. Of course, the national supervisors will still contribute to the work of the BIS. This approach would make the global financial system a safer place.